Don’t look down: Ignore the fiscal cliff, buy now

Make no mistake — the fiscal cliff is serious. But financial advisers should recognize that the looming threat doesn't necessarily mean that investors should reduce their market exposure.

In fact, some strategists are making the case for increasing risk through equities as the cliff comes into focus.

Based on stock and bond valuations, and factoring in various scenarios for managing the combination of scheduled year-end tax hikes and government spending cuts, it might be a good time to re-balance in favor of stocks over bonds.

“Right now, valuations are extreme, and that only makes sense if you think we're on the brink of a financial disaster,” said David Kelly, global chief strategist at J.P. Morgan Funds.

In essence, even considering concerns over an economic slowdown in China, continuing sovereign-debt issues in Europe and a fiscal cliff that theoretically could take a 3.5-percentage-point bite out of the U.S. economy next year, stocks remain too cheap to ignore.

The forward price-earnings ratio of the S&P 500 is now at 14, which is down from 27.4 at the market's valuation peak in December 1999 and still well below the 15-year average of 17.4.

“All we have to do is avoid the worst consequences of fiscal mismanagement,” Mr. Kelly said, re-emphasizing his rationale for steady equity exposure in spite of the fiscal-cliff threat.

Although avoiding a worst-case fiscal anything might seem a long shot, considering the rabid level of dysfunction in Washington, a certain amount of logic suggests that the full impact of the fiscal cliff is less likely than is a tamped-down version.

“NO GREAT SHAKES’

“Our sense is that the U.S. economy over the next year is likely to grow by around 2%, which is no great shakes, but it does have a little more activity to support earnings generation in corporate America, which is in pretty good shape,” said Tim Leach, chief investment officer at U.S. Bank Wealth Management.

He and others are reaching those slightly optimistic conclusions by factoring in some kind of fiscal compromise.

As he sees it, the fiscal cliff can be divided into two categories of economic growth representing 2.5 percentage points of tax increases and 1 percentage point of spending cuts.

“I think there's more give on the tax increase side,” Mr. Leach said. “And in a scenario of a less-than-full fiscal cliff, U.S. equities would probably fare reasonable well.”

Mr. Kelly has dug deep into the various possible scenarios, and he doesn't expect any action out of Washington prior to the November elections.

Beyond that, regardless of which party wins the White House and controls Congress, he thinks that there will be enough active compromise after the election to dial back the full impact of the cliff.

So whether the election produces a Democratic sweep of Congress and the White House, a Republican sweep of Congress and the White House, or some form of divided government, Mr. Kelly is anticipating — and hoping for — something akin to a “fiscal ladder.”

“The chances of a full fiscal cliff are extremely rare,” he said. “After the election, I think both parties will have a huge incentive to compromise.”

Whether that compromise takes the form of fewer tax hikes or fewer spending cuts, or a little of both, the end result is likely to be something less painful than the current path of suddenly trimming the deficit to 4% of gross domestic product next year, from 7.3% during this fiscal year.

“Bringing the deficit down is like lowering a piano from four stories; it needs to be done slowly,” Mr. Kelly said. “The key here is pacing, because a rapid drop will reduce aggregate demand in the economy, cuts in government spending will lead to huge government layoffs, and the tax increases on Americans will lead to a recession.”

Betting against such a doomsday scenario in an investment portfolio does require some confidence that politicians in Washington will be able to get something accomplished over the next few months.

Still, Mr. Kelly said that the consumer discretionary and consumer cyclical sectors will be the biggest beneficiaries of any reduction in the full impact of the fiscal cliff because the effects will be felt first in the U.S. economy.

With that in mind, sectors more tied to the global economy, including industrials, materials and technology, will enjoy less of a boost from fixes to the cliff.

“Even if we go to the ledge of the cliff, I would recommend a balanced portfolio because most investors are already very conservative, and right now, bonds are expensive and stocks are cheap,” Mr. Kelly said. “Based on the valuations right now, I don't think you should be too conservative.”

Questions, observations, stock tips? E-mail Jeff Benjamin at [email protected] Twitter: @jeff_benjamin